How much would you pay? Part 2

This is the second and final part of our series on How much would you pay?

You can read Part 1 here. This part 2 focusses on how to value stocks. We pick one company listed in BSE (called RACL Geartech) to walk through the various ways a stock valuation exercise can be undertaken.

We concluded Part-1 by saying this.

Now how much would you pay for a stock listed in BSE which makes Rs.10 in EPS (earnings per share) each year growing at 10% per annum? Aficionados of the Price/Equity ratio will jump at the opportunity and perhaps say that a PE of 25 will be reasonable and price the stock at Rs.250. While this is a reasonable thesis to pricing stocks, it is extremely incomplete. Accrual based accounting earnings mask several important features of the business, all of which have to be taken into consideration while undertaking a valuation exercise.

How much would you pay for a stock of RACL Geartech – A gear shaft auto-ancillary listed on BSE

RACL geartech is an auto-ancillary involved in the business of supplying gear shaft components to large OEMs across the world. They supply parts for passenger cars as well as motorcycles. It has been around for a long time, but it has made a lot of progress only in the last two decades. It is backed by an able promoter Gursharan Singh who has been with the business for the last 33 years! Export sales contribute to over 60% of revenue and it counts some of the most well-known OEMs as its clients including BMW, Kubota and Schaffler. Being a manufacturing business, it requires lots of capital and is particularly very working capital intensive. The cash conversion cycle is over 100 days in large measure due to linient customer payment terms as well as long shipping time of its products from India to its customer locations in Europe/elsewhere. Given that it is a microcap (Does sales of about Rs.200 crores & its current market cap is about Rs.260 crores), banks are less willing to fund the company’s expansion initiatives. Consequently, the business relies on raising equity capital through preferential share allotment. The promoters themselves have put money in and have participated in these fundraisings.

That hopefully gives you a broad brush of the business. Let’s dive straight into valuing this business and its stock.

What is value?

There are lots of different definitions of value. The one that we will rely on for this particular exercise is what is commonly called ‘intrinsic value’ – which is the value assigned to a business when theoretically given all the information there is to know about it. In the short run, the intrinsic value of a business usually does not change.

The market value of a business is the price at which it trades in the stock market. This changes every minute.

As savvy investors, our job is to find those businesses whose market value is less than their intrinsic value. And this is why equity valuation is such an important aspect of investing in stocks.

Equity Valuation – Approaches

There are so many different ways to valuing a company. If you don’t believe me, take a look at all the methods that valuation guru Aswath Damodaran has listed on his website.

The reason we have so many different valuation models is that no two companies are alike. Every business has its own unique set of circumstances – some pay dividends; some don’t. Some invest in R&D; some invest in manufacturing facilities. Some are in the early stage of their industry cycle; some are in the consolidation stage. Some are asset-heavy; some are asset-light. But the one thing they all have in common is that, in the long run, they all need to generate profits and convert these profits into cashflow. Nothing else matters.

In this post, and specific to RACL Geartech, we will look through the lens of 3 different equity valuation approaches, namely

  1. Comparables-based valuation,
  2. Residual income-based valuation and
  3. Free cash flow-based valuation (saving the best for last).

Note – Data for RACL Geartech comes from Screener.in. You can get it here

Comparables-based Valuation

Comparables-based valuation is a technique most people are familiar with and use. The key ratios used are – Price to Sales, Price to Earnings, Price to Cashflow, Price to Book-value and Enterprise Value related multiples EV/EBITDA and EV/Sales.

The idea behind this valuation methodology is to compare a particular stock’s ratios (in this case RACL Geartech) with that of its peer group and that of its industry average.

Here is a look at RACL geartech’s peer group and how they are relatively valued against each other on these metrics.

I have removed the decimals to make them easier to read. It does look like RACL geartech is valued at par in some of the metrics while it seems undervalued in some others.

Here are the ‘implied-prices/Enterprise Value’ based on the peer group average.

We don’t have meaningful P/E data for the peer group, so we have ignored it. But the other metrics, with the exception of EV/EBITDA, indicate that the stock is almost fairly valued.

Here is a look at the ‘implied-valuation’ based on the overall industry average. There are about 90 listed auto-ancillaries in India. We took the average ratios across all of them after ignoring the outliers.

This table again indicates that with the exception of P/E and EV/EBITDA, the other 4 valuation metrics imply that the stock is fairly valued. However, including those two, and considering the peer group based implied valuation, the average stock price discount seems to be about Rs.100 from its current market price indicating that its comparables based value is Rs.340 (vis-à-vis its market price of Rs.240).

Residual Income-based Valuation

Residual income is net income minus an equity charge. Let’s break that down. When a company has debt in its books, the cost of financing is charged to the income statement. However, equity, which like debt is also a source of capital for a business, does not get that same privilege. Equity owners make money only when the company decides to pay dividends. Residual income is a proxy to the ‘excess’ income a company earns after deducting a percentage charge to equity owners.

The table below shows residual income calculations for RACL Geartech for the last 3 years.

Once we have this, all we need to do to do valuation is to discount residual income using a one or two-stage model. Here is the formula for a single-stage residual income-based valuation.

Intrinsic value of a business = Current book value + Current Residual income/(cost of equity – growth rate of residual income)

For the two-stage valuation model, the residual incomes for each year in the first stage need to be calculated and discounted back. The final terminal value calculation is similar to a one-stage residual income valuation calculation. Here are the results of these calculations.

The intrinsic value calculated in both of these methods provides a similar sort of range. But that could be because of the assumptions I have made. But I think they are realistic. The indicative intrinsic value of about Rs.280 is slightly more than RACL Geartech’s current market price of Rs.240. It is however less than the comparables-based intrinsic value figure of Rs.340 we got earlier.

Free cashflow-based valuation

Free cash flow based valuations are easily the most preferred and thought to be the most reliable. They are best suited for mature companies. Companies at growth-stage that need a lot of capital infusion typically do not generate positive free cash flow. Two different types of cash flow based valuation techniques exist – 1) Free-cashflow to firm-based valuation and 2) Free-cashflow to equity-based valuation. The different between 1) and 2) being that 1) includes all cash flows, including those paid out to debt holders (finance cost, repayment of loans etc.) while 2) excludes these components.

Here is a look at RACL Geartech’s cashflow metrics over the last 4 years.

The company being in its growth-stages obviously is not generating positive cashflow except for the most recent year. But notice that both FCFF and FCFE are negative, which indicates that the company has to rely on equity capital to finance its growth. Here is a look at the total number of shares outstanding over the last 4 years, which confirms this trend.

Unfortunately, using free cash flow to value a company like RACL geartech would not produce very reliable results. But for the sake of it, we will do it anyway. The valuation technique is similar in that it can either be a single-stage or multi-stage discounted valuation. We will use the FCFF to calculate intrinsic value by discounting it at the company’s weighted average cost of capital. It is about 50%-50% funded by Debt and Equity. Assuming that cost of equity is 12% and cost of Debt is 10%, WACC works out to about 11%.

Single-stage FCFF based valuation

FCFF based valuation suggests an intrinsic Value of about Rs.305.

Conclusion

We used three different valuation models and here are the intrinsic values of RACL geartech based on them.

  1. Comparables-based valuation – Rs.340
  2. Residual income-based valuation – Rs.280
  3. Free cashflow to firm-based valuation – Rs.305

The average of all these three is about Rs.310, which is 27% more than the company’s current market price of Rs.243. For a value-based investor, this is a sufficient margin of safety to make an investment.

Disclaimer: This column is meant for educational purposes only and it is not meant to be investment advice. I hold shares of RACL geartech in my portfolio and my views may be biased.

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